21st March 2023

A viewpoint from Anatoly Crachilov, CEO and Founding Partner at Nickel Digital, on Silicon Valley Bank’s(SVB) recent collapse

Anatoly Crachilov comments:

"Silicon Valley Bank, which served the tech sector for over 40 years, collapsed in the matter of a few days. This is significant not only because SVB has grown to become a top-20 US bank by total assets(in fact, of the same size as Morgan Stanley PB and well ahead of AmEx), but because its failure has highlighted accounting arrangements that allow banks to legally conceal accumulated losses.

The daily mark-to-market approach implies that trading assets are carried on their fair value, i.e. the closing price of each trading day. However, current accounting standards allow banks to carry some securities at their original acquisition price without the need for mark-to-market, as long as they are formally classified as "held to maturity"(HTM).

What normally would be held in this basket? Longer-term fixed securities, sometimes 5-10 years and over, which supposedly represent part of the banks’ long-term portfolio allocation. Any interim losses emerging from such a portfolio would NOT be recognised in the bank’s books.

However, in the case of SVB, the "unrecognised" losses in their HTM portfolio grew to staggering proportions. In Q3 2022, the HTM portfolio contained $15.9bn of unrelaised losses compared to just $11.5bn of the bank's tangible common equity. Effectively, SVB has been insolvent since at least last September.

How did that happen? Fixed income instruments have an inverse correlation with the interest rates, and in a rising rate environment holding even “innocent” US Treasuries may inflict life-threatening losses. Indeed, Treasuries are regarded as risk-free investments from the point of view of the issuer's default, but they do not spare you from negative mark-to-market. In SVB's case, the $88bn HTM portfolio resulted in nearly $16bn of losses by September 2022, a rather mind-blowing 18% markdown.

The ability to avoid reflecting the true market value of the loss-making portfolio allowed for artificially dampening the volatility of the SVB earnings, up until it had to urgently liquidate the book to cover rapid deposit outflow, thus crystallizing multi-billion losses.

While many analysts argue that SVB's case is rather idiosyncratic due to fragile structure of its deposit base, it seems that the issue of concealed losses might be a rather widespread phenomenon that contaminated many banks.

It is only a matter of time until market pressure forces weaker players to liquidate their fixed-income portfolios, crystallising embedded losses. While the major banks are in a better position to absorb such an impact, smaller banks might come under unsurmountable pressure, leading into bankruptcy oblivion.

It appears that the Fed's recklessly aggressive interest rate policy(prompted by its preceding failure to stay ahead of the curve) has sculpted a number of "zombie” banks, the full scale of which is yet to be revealed.

Nickel Digital Trends(15 articles)